Finding the next dividend-paying stars

How to look for tomorrow’s high-yielding stocks

JackHough

Cisco Systems shareholders had a good week — one that highlights an opportunity for other investors.

On Wednesday, the technology company
CSCO, +0.75%
announced it will boost its quarterly dividend to 14 cents a share from 8 cents.

That might not sound like much, but it was enough to raise the stock’s dividend yield — a year’s worth of dividend payments as a percentage of the stock price — to 3.2% from 1.8%, based on Wednesday’s close.

Wall Street's finest at work

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"Great quarter, guys." For those who have been too busy to tune in to company earnings calls, that's a dollop of praise analysts have lately ladled over companies ranging from Broadcom to Bonanza Creek Energy.

For stock buyers, one ticket to share-price gains may be to look for tomorrow’s high yielders — companies that, like Cisco, offer the potential for fast dividend growth.

That is because investors are paying premium prices for companies that can deliver big dividends, a group that has traditionally included utilities, real-estate investment trusts and companies that make consumer staples like food.

Just look at the S&P 500’s dividend payers ranked by “payout percentage,” or the portion of earnings they pay as dividends. The top-paying half sells for a median of 16 times projected earnings, versus 12 times for the bottom-paying half.

One reason investors may be favoring stocks with generous dividends is that bond yields have become stingy. On average over the past 50 years, the 10-year Treasury note
TMUBMUSD10Y, -0.63%
yielded about 3.5 percentage points more than the S&P 500. Now it yields less. During the past half-century, that has happened only once, in late 2008 and early 2009, when the stock market hit its financial-crisis low.

Finding likely dividend growers is getting easier: A dozen S&P 500 members have started making payments this year, bringing the total number of payers to 402, the highest since 1999.

Investors can look beyond traditional dividend-paying sectors. Thanks to Cisco’s payment spike, for example, the technology sector is now the largest source of dividends by dollar amount, edging out consumer-staples stocks.

Companies have plenty of room to increase their payments. Not only are cash balances near record levels, but S&P 500 dividends are just 33% of earnings, versus a long-term average of over 50%, according to Howard Silverblatt, an index analyst at S&P.

To search for companies with dividend-growth potential, one key clue is a low payout percentage — less than half of earnings, says John Gould, a portfolio manager at Schafer Cullen Capital Management in New York, which oversees $12 billion.

Indeed, the bottom half of S&P 500 companies, as ranked by payout percentage, increased dividends at a median rate of 12% over the past year, versus 8% for the top half. They also had faster revenue growth.

Reuters

Walt Disney Co. is among the companies that have tended to boost dividends toward the end of the year.

These include companies like UnitedHealth Group
UNH, -1.38%
which announced a 31% payment increase in June, and Parker Hannifin
P, -0.85%
which has raised its dividend in seven of the past nine quarters. There also are companies that tend to boost their dividends late in the year. Walt Disney
DIS, -0.30%
announced a 50% increase last November, and clothing maker VF
VFC, +0.41%
a 14% one in October. Each of these stocks still yields less than the S&P 500.

Likely dividend growers also have modest debt levels and high levels of “free cash flow” — in other words, plenty of funds left over after paying for current expenses and long-term investments, Gould says.

Another good clue is a past record of dividend growth, says Sudhir Nanda, head of quantitative stock research at mutual-fund company T. Rowe Price Group.

A low dividend yield doesn’t necessarily suggest payments are bound to rise, Nanda says. The yield might be low simply because the shares have gotten expensive, or the company might pay small, token dividends but not show a serious commitment to returning capital to investors.

Likewise, don’t rule out all high-yielding stocks, says Kate Mead, co-manager of the $20 billion MFS Value fund. For dividend-growth potential, she likes tech consultants Accenture
ACN, -0.25%
and IBM
IBM, -0.47%
which yield 2.2% and 1.7%, respectively, but also Intel
INTC, -0.03%
which yields 3.4% but pays only 38% of this year’s projected earnings as dividends. All three are big cash generators.

Schafer Cullen’s Gould calls discount retailer Family Dollar Stores
FDO, +0.00%
an “emerging dividend payer.” The company increased its dividend by 17% in January, and it now yields 1.3%. He also likes the dividend-growth prospects of Emerson Electric
EMR, -0.11%
, which yields 3.2% and has raised payments for 55 consecutive years.

For mutual-fund investors, T. Rowe Price Dividend Growth has a yield of only 1.5%, but it has returned an average of 3.2% in price gains and dividends over the past five years, versus 2.3% for the S&P 500, according to investment-research firm Morningstar. That ranks it among the top 15% of funds that invest in a blend of large companies. It charges a moderate annual fee of 0.68%, with no upfront sales charge.

Then again, one of the cheapest choices in the category has turned in even better returns. Vanguard Dividend Appreciation
VIG, -0.23%
, an exchange-traded fund that yields 2.3%, tracks an index of consistent dividend-growers rather than relying on stock picks. That keeps costs down to 0.13% of assets per year, and the fund has returned an average of 4.4% over the past five years, ranking among the top 5% of peers, according to Morningstar.

If the dividends those funds pay look unexciting, just wait seven years. Assuming 10% yearly dividend growth, the market’s median pace over the past year, that is just about enough time for payments to double.

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